Should We Diversify Managers?

Even inexperienced investors understand that diversification is important (eggs in baskets and all that). So does it make sense to spread your investments across different advisers and fund managers?

At first glance, this seems sensible. However, in most cases at least, diversifying across advisers and managers offers no real benefit.

What do we mean by diversification?

When we talk about diversification, we are referring to purchasing a range of investments to spread risk.

Let's say you were only investing in shares and your first purchase was Walmart. What are some of the things we know about Walmart which describe the associated risks?

Walmart is a chain of retail stores based in the USA. If we were to choose Amazon as our second purchase, we would be diversifying some risk; if Walmart does poorly, Amazon may be doing well.

But Amazon is also largely focused on retail in the USA. So we haven't really reduced our exposure to the risk of something happening in the retail market or something happening to the USA as a whole.

Any manager worth their salt will account for country risk and sector risk when choosing the shares in a portfolio.

Isn't using different managers diversifying?

It seems to follow that the same would apply to managers and advisers. Why put all your faith in one investment strategy or a single manager's products?

The issue is all the managers and advisers are choosing from the same pool of companies.

For example, think of ride-share apps like Uber and Ola, plus regular cab companies. Most of the drivers are on both services, even the cab drivers. So it doesn't matter which you choose, the same driver will show up regardless.

If the different managers are focused on the same market, you likely haven't added any diversification by using two. If one of the managers is Dimensional or an index fund, you almost certainly have not.

What happens if the manager fails?

Your funds should never be accessible by the manager's creditors. Investment products are set up as trusts, where investors buy a small part. The assets are held by an independent custodian (in Dimensional's case, this is Citibank) who receives and carries out the instructions of the manager.

If a manager went under, the client assets would still be held by the custodian. There is no way a failing manager could use client funds to cover their liabilities. The custodian and regulator will appoint a new manager and funds will continue to be available.

Oracle Animals - Luck vs Skill

We are all disappointed by the All Blacks loss against a strong England team, especially when many picked the All Blacks to go on to win the cup.

However, we can't win them all and predictions are often wrong. I find myself interested in the sources of these predictions, especially the more absurd.

Animal oracles often make headlines during major sporting events. The German octopus Paul garnered worldwide attention for predicting outcomes for football games. He made 12 correct predictions out of 14, including 8 out of 8 during the 2008 FIFA World Cup.

New Zealand had their own oracle Sonny Wool, a sheep who picked 7/10 results during the 2011 Rugby World Cup, correct for the All Black games. Other examples include Mani the parakeet, Leon the porcupine and Petty the pygmy hippopotamus.

While it would be daft to place bets based on the opinions of a mollusc, the stories are none the less entertaining. They also offer examples of interesting concepts and lessons for investors (bear with me).

Survivorship Bias

How we overlook what is missing

Sometimes the data that is missing is integral to the overall picture. The most famous example is regarding planes returning from combat during World War Two.

“... For example, in WWII, a team was asked where the best place was to fit armour to a plane. The planes that came back from battle had bullet holes everywhere except the engine and cockpit. The team decided it was best to fit armour where there were no bullet holes, because planes shot in those places had not returned.”

— www.geckoboard.com

Paul the Octopus looks clairvoyant on his own, but we don't read articles about animals making lousy predictions. If we believe his choices were due to chance, the chance of being right 8 times in a row is only 0.4%. But if we have 250 different animals making predictions, we'd expect one to choose correctly. Then the media picks up on the successful one and the rest are ignored.

Survivorship is literal for another ill-fated oracle octopus named Rabio, who predicted the outcomes of all four of Japan's group games in the 2018 FIFA World Cup. Before he could weigh in on the next game, Rabio was sold and presumably turned into sashimi.

This bias is important when evaluating active investment managers both individually and in aggregate. If you were to visit a manager's website, you would not likely see a list of funds closed due to underperformance. So the funds that remain make the manager look much more impressive.

Dimensional looked at a sample of 2,786 US mutual funds over a 15-year period to the end of 2018. Only 18% of them outperformed their benchmarks and nearly half closed over the period. If we were only to consider the funds lasting the full 15 years, we would see 36% outperforming their benchmarks, which seems much better than the full picture.

Skill vs Chance

Can we see the difference?

Most would assume Paul's success is due to luck not skill because there is no reasonable explanation for an octopus understanding a football world cup. We can chalk it up to one lucky animal out of a huge sample.

Like the lottery, it is likely someone will win, but very unlikely a particular person will win. As there are many oracle animals, we expect a few to be right.
 
With active managers, it is more difficult to accept the evidence that chance is a bigger determining factor than skill. You would expect an industry of people specialising in picking stocks would do better than, for example, a collection of oracle animals. But the evidence suggests the performance of both are explained by chance.

S&P's persistence scorecard takes the top 25% performing managers for a given year and checks how many stay in the top 25% for the next year. If their high returns were due to chance and not skill, we would expect a quarter to remain in the top 25%. Lo and behold, this is exactly what the data shows.

So while an octopus (or a cat) may not understand how to analyse a stock price or manage risk, if you are considering long-term performance, it would be on the same level as an active manager.

Though I assume the octopus would charge lower fees.

Tips to Bank Better

In order to minimise costs and make your life easier, it is well worth checking over how your accounts are set up and having a look at other services available through online banking. Here are a few things to consider to make your banking better.

Check your accounts

On-call accounts

These accounts should be your "busy" accounts, where money frequently flows in and out. They typically have low transaction fees but low interest. Things to look out for:

• If you have more cash in your on-call accounts than is needed for spending each month, transfer the surplus to a higher interest account or investment

• Check if you have an overdraft set up and cancel if it is not needed

• While most accounts do not charge for online transactions, many do charge "manual transaction" fees if you visit your branch

You will save money by doing the majority of your banking online with the appropriate account. However, if you prefer to visit your local branch, consider an account which charges less for manual transactions.

Savings accounts

Savings accounts are great for short-term goals or keeping an emergency fund. The interest rates are higher than on-call accounts but with penalties for transactions.

• If you have much more in your savings than you will realistically need for your short-term goals plus an emergency, consider shifting the extra to a better investment

• Check whether you are incurring costs or forgoing interest with frequent transactions. If so, consider keeping more cash in on-call accounts for these withdrawals

• Compare interest rates between different account types for the amount you are saving and the time-frame

For your savings account, make sure you are limiting withdrawals. Also, instead of making payments from this account, it is usually better to first transfer to your on-call account to reduce fees paid.

Credit cards

Having a credit card is great for regular spending, if you are disciplined in paying the full balance each month. When choosing a card, consider the benefits against the costs.

• Consider how much you spend each month and compare the expected rewards earned to the fees paid

• Choose a sensible credit limit based on your monthly spending

• Pay your balance! The interest on credit cards is extortionate. It is better to transfer from other accounts onto your balance than let interest accrue on the card

If you find yourself unable to pay the full balance at the end of each month, a debit card may be preferable. Debit cards work in the same way as credit cards, but you can only access your own money instead of credit from the bank. Your credit limit can also be used as a rough budget for monthly spending.

Automate your finances!

Automatic bill payments

Setting up automatic payments for your insurance, utilities and other regular payments is easy with online banking. Not only will you never miss a payment, but many companies offer discounts for automatic payments! Power companies offer a prompt payment discount as high as 20% for paying on time, which you will never miss with an automatic payment.

Automatic payments help you stay on budget

As most banks do not charge fees for transferring between accounts, automatic payments can be great for budgeting. Here are some ways you can set up your automatic transfers to pay yourself first:

• Set up a transfer on payday to your savings account(s) to make saving for a holiday easier

• Automatically transfer from your regular account to a designated on-call spending account to better track your spending

• Set up a regular transfer to your investment accounts to maintain discipline and benefit from dollar-cost averaging

Most importantly, set up your accounts and payments to work for you. Some of the strategies I've come across are:

• Setting up payments to a spending account to budget better, anything left over is savings.

• A friend of mine has a savings account with a separate bank, with automatic payments each payday. The one day delay dissuades him from dipping into his savings.

• Another friend has separate accounts and automatic transfers for utilities, regular expenses and "luxury" spending, to help track his spending habits.

Manage costs

There are fees and costs you may not realise you are paying or are not getting value from. Keep an eye out for:

• Paper fees - Most banks now charge a fee for posting bank statements. Go paperless, receive statements via email and save yourself the cost.

• Manual transaction fees - If you are frequently paying fees for payments and withdrawals, consider changing your account types or changing the way you move money around

• Overdraft fees - You may be paying for overdraft facitilities you don't need. If you never go into overdraft, consider cancelling this service

• Interest payments - If you find you are paying interest on your credit cards or overdraft, pay down your debts where possible. Otherwise, focus payments on high interest debt

• Other account fees - As described above, there may be different account types that save you money

Most importantly, check your monthly statement! Even if you don't get around to it every month, you will often pick up on fees you didn't realise you were paying, subscriptions you don't use and spending habits you might have missed. Many free trials require you to enter your card details (Neon TV and Spotify come to mind) and start charging you when the trial ends.

Useful banking tools

Tracking spending

If you don't like budgeting, you can still glean useful information from basic tools on your online banking login. For example, with ASB's "Track My Spending" option, just choose the account(s) you want to look at and you will get a summary of total income and total spending each month for the past year. You can easily see your average monthly income/spending and whether you are running a surplus or deficit. Most banks will also have the option to "code" past transactions into categories, so you can also look at how much you spent on different areas, such as utilities or eating out.

Budgeting and net worth

If you want to take a deeper dive into budgeting, there are work sheets where you can estimate your monthly spending in different categories. Also, you can track your assets and liabilities to estimate your net wealth. While understanding your net incomes vs net spending helps for planning ahead, having a budget helps identify and manage bad spending habits to save you money.

Save the change

A new feature offered by many banks is "Save the Change", where purchases are rounded up to the nearest $1 or $10 and the extra is transferred directly to your savings account. It works in the same way as a digital piggy bank. This is a great way to squirrel away a bit of savings each time you spend.